The Value of a Dynasty Trust

With five children and 10 grandchildren, Joseph Newman thinks of himself as a patriarch. Like many hardworking Americans, Joe and his wife, Deb, were interested in an estate plan that provided for more than one generation of their heirs. At their first meeting with a member of the Wealth Protection Network® team, much of the discussion centered on how to provide for their 10 grandchildren. The Newmans were disturbed to learn that not one but two taxes would apply to any sizable gifts (above their gift tax exemptions) made directly to their grandchildren.

It was estimated that at the moment Joe and Deb passed away, 40 percent of their estate would be lost to estate taxes. They were outraged when they realized that the IRS would confiscate another 40 percent when the remainder of their estate passes from their children to their grandchildren. Without a plan, the Newmans’ estate would be worth less than 22 percent of its value today after only three generations of taxation.

The Newmans were pleased to learn that, by setting up a trust and funding it while they are alive, the trust would enable them to leverage their various exemptions and avoid the estate taxes that would be due at each generation. Through dynasty trust planning, their estate remains intact for the benefit of their children, grandchildren, great-grandchildren and even later generations. In addition, Joe and Deb learned that the dynasty trust also protects the assets they leave in the trust for their heirs from the claims of creditors, predators and divorcing spouses.

If your years of hard work and diligent savings have yielded some wealth, the thought of having the IRS take a large bite (up to 40 percent) of these assets may be very painful. Unfortunately, as the wealth passes down the family tree, successive application of estate taxes may significantly erode the amount that later generations will inherit.

If you want to leave tax-free wealth to your children, grandchildren and future generations, consider using a generation-skipping trust. The name belies the true value of the trust because the only one that is “skipped” is the IRS. Therefore, a more appropriate name is the dynasty trust (also referred to as the D trust or descendant’s trust). Coupled with life insurance, the dynasty trust becomes a powerful tool for maximizing wealth for generations to come.

Consider the radically different results for the grandchildren in the following two examples, in which a grandfather wants to transfer $15 million:

No planning: At the grandfather’s death, federal and state death taxes reduce the $15 million by approximately $4 million. If the after-tax wealth passes to his daughter and remains intact during her lifetime, at her death the remaining $11 million will be further eroded by approximately $2.4 million in estate taxes, leaving a balance of $8.6 million for her children. Thus, the $15 million that the grandfather had at his death has been reduced to $8.6 million by the time it reaches his grandchildren. Because of the generation-skipping transfer (GST) tax, even if the grandfather left his entire estate directly to his grandchildren, they would receive only $8.6 million. This is true even if the grandfather took advantage of his GST tax exemption of $5 million ($5.34 million, indexed for inflation, as of 2014).

Comprehensive planning with a dynasty trust: To avoid the large estate tax bite for two successive generations, the grandfather leverages his GST tax exemption of $5 million ($5.34 million, indexed for inflation, as of 2014) through a dynasty trust. The terms of the trust allow the trustee to distribute trust property to his daughter, as needed, but the trust is not subject to estate tax when his daughter dies. After the daughter’s death, the property remains in trust for the benefit of her children and their descendants. With this planning, the grandfather is able to pass approximately $11 million (possibly more, due to growth) to his daughter, grandchildren and great-grandchildren.

Under federal and many states’ laws, all assets are subject to estate taxes when they pass from generation to generation. A dynasty trust, however, is designed to maximize your available estate and GST tax exemptions and keep assets from ever being subject to gift, estate or generation-skipping tax.

Dynasty Trust Basics

A dynasty trust is an irrevocable trust created for the benefit of the grantor’s descendants (children, grandchildren and so on) to which the grantor allocates all or a portion of his or her GST exemption. If the grantor is married and his or her spouse participates in making transfers to the trust, a total GST exemption of approximately $10 million (subject to previously noted increases) is available.

Once exempt from GST tax, the trust property, and all appreciation in value and income, remains free from further federal transfer taxes for the life of the trust. It is also free from the claims of creditors. Given the effects of compounding, a successfully invested trust can accumulate to a value of tens of millions of dollars, available to future generations of beneficiaries undiminished by estate or generation-skipping tax costs.

Objectives

The primary objectives of a dynasty trust are:

– To receive cash or other assets as gifts that can be invested, used to pay the premiums of life insurance, or both, on either or both the grantor or the grantor’s spouse.

– To escape gift, estate and generation-skipping taxes on the assets and any growth therein (such as insurance proceeds) for the life of the trust.

– To maximize and leverage the available GST exemption amount, without paying gift tax, by investing in growth stocks, and similar instruments, or by purchasing life insurance on the life of the grantor or the lives of the grantor and his or her spouse, or both of these.

A dynasty trust permits wealthy individuals to preserve and create wealth to provide a lasting legacy for future generations. This is accomplished by transferring property to a trust for the longest possible period of time and structuring the trust so that no part of the principal that remains in trust will be included in the estate of any descendant.

Leveraging Your Exemption

A dynasty trust may be created during the grantor’s lifetime or at death. The advantage of the GST exemption is magnified if it is used during life because, once property is transferred to a dynasty trust within the exemption, all appreciation and accumulated income generated by the property is exempt as well. As a result, in most cases the trust holds more property when the grantor dies than could be placed into the trust within the exemptions at the grantor’s death.

By transferring property to a dynasty trust during life, the grantor makes a taxable gift, which may require the grantor pay gift taxes. In order to avoid gift taxes, many individuals prefer to fund a dynasty trust with gifts shielded from tax by using their annual gift tax exclusion amount ($14,000 per beneficiary in 2014) and/or their available lifetime exemption.

Benefits of a Dynasty Trust

A properly executed dynasty trust will provide several advantages for trustees and beneficiaries as it can:

– Receive cash or other assets as gifts that can be invested for the benefit of several generations of family members, free from the claims of creditors;

– Avoid gift, estate and generation-skipping transfer taxes on the assets and any growth thereon for the life of the trust; and

– Maximize and leverage the available GST exemption amount, without paying gift tax, by investing in growth stocks and the like and/or by purchasing life insurance on the life of the grantor or the lives of the grantor and his or her spouse.

Continuity of Exemptions

In addition to avoiding gift or estate taxes on the trust asset’s appreciation and accumulated income, lifetime funding of a dynasty trust offers other benefits. Because a dynasty trust is irrevocable, future changes in the transfer tax laws should not affect it. Thus, the grantor is assured of receiving the benefits of the GST exemption and any lifetime exemption amounts used in funding the trust, and those benefits should not be eliminated if the exemption is reduced in the future. As the GST exemption is adjusted, as noted earlier, it is possible to add to the trust beyond the initial GST tax exemption ($5.34 million in 2014, indexed for inflation annually). Of course, the income taxation of the trust income will be subject to the income tax laws and any changes to those laws.

Taxation

To avoid the higher income tax rates that apply to trust income, the trust can be drafted so that any trust income is taxed to the grantor while alive. This is accomplished by designing the trust as a grantor trust subject to the IRS’s grantor trust rules. This provides an added benefit for the beneficiaries, as the trust can retain and invest funds that would have otherwise been paid out for income taxes.

Disadvantages of the Dynasty Trust

As with all planning strategies, there are a few drawbacks associated with an estate plan utilizing a dynasty trust. Because the dynasty trust is irrevocable, it is essential that both the grantor and his or her advisors have a clear understanding of its operation in light of the objectives involved before implementing a dynasty trust.

One problem with a dynasty trust is the grantor’s loss of income and net worth when he or she funds the trust. Once gifts are made to a dynasty trust by the grantor, the assets and the future income from them are irrevocably gone. However, a married grantor may name a spouse as a beneficiary of his or her dynasty trust, thereby benefiting indirectly from the trust as long as that spouse is alive. Thus, even though the dynasty trust is often referred to as a generation-skipping trust, it doesn’t have to skip or disinherit anyone.

Another drawback is the administration required with a dynasty trust. Choosing the right trustees and ensuring compliance with the rules regarding demand-right, “Crummey” beneficiaries is critical. In addition, the monitoring of life insurance and/or other investments owned by the trust is important to ensure that the goals of the dynasty trust are met.

The Rule Against Perpetuities

A dynasty trust is typically structured to continue in existence for the maximum period of time permitted under applicable state law. In most states, this legal maximum is limited by a doctrine known as the rule against perpetuities. Under this rule, the typical trust must come to an end after about 80 to 100 years. Thus, state law effectively limits the estate tax, creditor and divorce protection benefits of the trust vehicle to this period of time. At the end of the period, trust assets must be distributed and will be subject to estate or gift taxes—which often results in family holdings being sold. For example, the sale of the Boston Globe was prompted by the expiration of family trusts that had owned the newspaper since 1872.

Some states have adopted a statute that allows for a flat period of 90 or more years before a trust must terminate. Although it is not necessary for a dynasty trust to continue for the full 90 years, by doing so, the trust property can be sheltered from transfer taxes for the longest possible time. States that have adopted a flat period of years (from 90 years to 360 years, depending on the state) include: Alabama, Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Florida, Georgia, Hawaii, Indiana, Kansas, Massachusetts, Minnesota, Montana, Nebraska, Nevada, New Jersey, New Mexico, North Carolina, North Dakota, Oregon, South Carolina, South Dakota, Tennessee, Utah, Virginia, Washington and West Virginia.

States that have abolished the rule against perpetuities include: Alaska, Idaho, Kentucky, New Jersey, Pennsylvania, and South Dakota. Therefore, trusts created and/or administered using one of these state’s laws may continue forever and grow without the threat of the federal transfer tax system consuming a huge portion of trust assets. Other states have drastically increased the number of years before a trust must end. For example, Florida permits trusts to last for 360 years.

Of the states that have eliminated the rule against perpetuities, Alaska and South Dakota give a dynasty trust the best edge because they have no state income tax. In addition, Florida does not have a state income tax. If the trust is set up in one of these states, more of its income can stay in the trust without being subject to state income taxes so the trust will grow even faster.

As you can see, the state where the trust is set up can make a big difference.